This Client Update is the first segment in a three-part series on the new or proposed Securities and Exchange Commission rules governing private placements, mandated under the JOBS Act and the Dodd-Frank Act. This update, Part 1, focuses on the new rules lifting the ban on general solicitation and general advertising in certain private placements of securities. Part 2 will cover the rules governing offerings that are associated with "bad actors." Part 3 will cover the SEC's proposed changes to Form D, the notice filing made with the SEC in connection with private placements.
Historically, sales of securities under the Securities Act were made either to the general public through a registered public offering or privately to qualified investors in private placements. In order to take advantage of the "private" placement exemption from registration, a basic requirement was that there could be no general solicitation or advertising to the general public. Congress, in the JOBS Act, mandated that the SEC nevertheless adopt rules eliminating the prohibition on general solicitation in certain private offerings, which it has done in final rules effective September 23, 2013.
Old Rule 506: No General Solicitation, Ever
The most frequently used alternative under the current Regulation D private placement exemption from registration is known as Rule 506, which permits offers and sales in an unlimited amount to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors. In order to take advantage of Rule 506, companies could not engage in any form of general solicitation. General solicitation does not have a precise definition but, in order to protect investors, the SEC construed the term broadly to include newspaper advertising, television and radio, websites, and e-mail, as well as seminars where attendees were invited using advertising. For issuers or their placement agents who do not need to advertise to find investors, the SEC has preserved the current rule in a redesignated section called Rule 506(b) that is unchanged except for the addition of a restriction prohibiting the use of the rule by "bad actors," which will be discussed in Part 2 of this Client Update. With this qualification, therefore, if companies do not want or need to advertise, they can continue to rely on the current exemptive rule to make sales to accredited investors and up to 35 non-accredited investors.
New Rule 506: General Solicitation, Sometimes
The JOBS Act mandated that the SEC amend Rule 506 to enable companies to use general solicitation and general advertising in private offerings, as long as they make sales only to accredited investors. Accredited investors generally include (1) registered brokers or dealers, banks, registered investment companies, insurance companies, and business development companies; (2) certain companies, trusts and employee benefit plans with assets of $5 million or more; and (3) individuals who either have a net worth of $1 million or more, excluding the value of the individual's home, or have had an individual income of $200,000 or more for the past two years ($300,000 with a spouse), and reasonably expect to have the same income in the current year.
Verifying Accredited Investor Status
The new exemption is set forth in Rule 506(c) and provides that issuers may engage in general solicitation and advertising in a private placement, so long as the company takes reasonable steps to verify that all purchasers (not offerees) of the securities are accredited investors and the issuer reasonably believes all the purchasers to be accredited investors. The SEC did not mandate specific methods of verification, but rather set out a principles-based approach and several non-exclusive, non-mandatory methods that may be used to verify accredited investor status. Whether the steps taken are reasonable in a particular offering is to be an objective determination by the company, or its placement agent, taking into account the facts and circumstances of each purchaser. Factors to be considered under the principles-based approach include:
- the nature of the purchaser and the type of accredited investor the purchaser claims to be.
- the amount and type of information the company has about the purchaser.
- the nature of the offering, the manner in which the purchaser was solicited, and the terms of the offering, such as the minimum investment amount.
Note that an affirmative "yes" from an investor, whether checking a box online or signing an investor questionnaire in person, without more, is not enough to satisfy this standard.
In response to many comments, the SEC also provided a non-exclusive list of "reasonable" verification methods for natural persons. By conducting any of the following, an issuer may be deemed to have satisfied the verification requirement:
- Individual Income Requirement: The issuer reviews relevant IRS reports, such as Forms W-2, Schedules K-1 or Forms 1099, for the previous two years, and also obtains a written representation from the investor that he or she expects to earn the same income in the coming year.
- Individual Net Worth Requirement: The issuer reviews certain forms indicating that the investor has sufficient assets, such as bank statements, brokerage statements, tax assessments, and appraisal reports, all of which must have been issued within the past three months. The issuer must also check the investor's credit report, issued by a nationwide consumer reporting agency, to confirm that the investor's liabilities do not decrease the investor's assets to such an extent that the investor fails to meet the net worth requirement. Finally, the issuer must obtain the investor's written representation that the investor has disclosed all of his or her liabilities necessary to make a determination of net worth.
- Third-Party Verification: If a registered broker-dealer, registered investment advisor, licensed attorney, or certified public accountant has, within the past three months, confirmed that the investor is accredited, then an issuer may rely on that professional's written representation. Commenters expect that some companies may begin offering third-party verification services in response to this part of the new rule.
- Current Investor Verification: If any individual has previously invested in the issuer as an accredited investor, and remains an investor, that individual can certify to the issuer that he or she is accredited after the rule takes effect.
Implications and Interpretations
The following practical considerations should be taken into account by companies before undertaking a private offering employing general solicitation in reliance on Rule 506(c):
- The statutory private placement exemption in Section 4(a)(2) of the Securities Act remains available, but continues to prohibit general solicitation. Companies therefore will need to strictly comply with all the requirements of Rule 506(c) because, if they use general solicitation, then Section 4(a)(2) will not be an available fallback exemption for a failed Rule 506(c) offering.
- Rules 506(b) and 506(c) are two distinct rules. Rule 506(b) allows issuers to sell privately to up to 35 non-accredited investors, as well as an unlimited number of accredited investors. Rule 506(c) allows issuers to use general solicitation and general advertising, but sell only to accredited investors. If a company wants to use general solicitation for an offering, the company cannot make any sales to non-accredited investors as part of that offering. If the company wants to sell to non-accredited investors, the company cannot use general solicitation.
- New Rule 506(c) is a regulation issued under Section 4(a)(2) of the Securities Act. Securities issued in Rule 506(c) offerings will be "covered securities" for purposes of state blue sky exemptions from registration, and state blue sky laws that would not apply to other Rule 506 offerings will therefore not apply to Rule 506(c) offerings.
- Funds that engage in private offerings–such as hedge funds, private equity funds and venture capital funds–rely on certain exclusions from the Investment Company Act that are conditioned on the funds not making a public offering. The SEC confirmed in its adopting release that exempt offers by these funds under Rule 506(c), using general solicitation or advertising, will not jeopardize these exclusions under the Investment Company Act.
- Although many commenters urged the SEC to state that if all investors were, in fact, accredited, then the issuer had conducted a proper investigation of accredited investor status, the SEC declined to adopt this position. Instead, the SEC made it clear that an issuer must affirmatively verify that each investor is accredited in advance of accepting an investment under Rule 506(c). Therefore, even if every ultimate investor is accredited, the exemption will not be available if the issuer has failed to comply with the verification requirement.
- In transition guidance, the SEC did specify that if issuers begin a Rule 506 offering now, that issuer can begin using general solicitation under Rule 506(c) after the rule amendment becomes effective without affecting the exempt status of the rest of its offering that took place in reliance on what will become Rule 506(b).
- The SEC also amended Rule 144A, a resale exemption used in the institutional market, to provide that offers to persons, other than qualified institutional buyers, including offers by general solicitation, are permitted as long as actual sales are made only to persons the seller or any person acting on behalf of the seller reasonably believes are qualified institutional buyers.
Part 2 of this Client Update will explain how the SEC's "bad actor" rule amendments, adopted on the same day as the rules related to the lifting of the ban on general solicitation, may disqualify some companies, placement agents, finders and others from using Rule 506 for private offerings.
This client update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions regarding this client update, please contact your principal attorney at Tonkon Torp LLP, or Tom Palmer, Drea Schmidt, or Claire Brown of our Corporate Finance Practice Group .